Managing personal finances can be challenging at the best of times, but when unexpected costs leave you needing additional funds, an overdraft can be a financial lifesaver. Overdrafts can be a helpful way to access money, and banks offer them to ensure customers can make important transactions and withdraw cash, even when their balance is low.
While overdrafts can be highly beneficial, they can also get people into debt, and you should understand how to use an overdraft before applying for one.
In this guide, we’ll explain everything you need to know about overdrafts and provide some great tips so you can make the most of yours.
What is an overdraft?
An overdraft is a short-term borrowing facility that gives you immediate access to funds when your account balance reaches zero or goes into a negative balance.
When you initiate a transaction that exceeds the available funds in your account, the bank covers the shortfall through an overdraft. The bank charges interest on the borrowed amount until you replenish your account.
How do overdrafts work?
Before 2020, there were two types of overdrafts; arranged/authorised or unarranged/unauthorised:
Arranged Overdraft: When you applied for an arranged overdraft limit with your bank, there was an interest-free amount. For example, an overdraft of £500 didn’t incur any interest as long as you didn’t exceed that limit.
Unarranged Overdraft: An unarranged overdraft would often incur fees if you went into your overdraft. These fees were often much higher than arranged overdrafts and charged customers each day they were overdrawn.
In April 2020, the FCA banned banks from charging higher rates on unsecured overdrafts to prevent people from falling into serious debt. Instead, banks now charge a single interest rate to overdrawn individuals, which limits the money you can make for unarranged overdraft spending.
However, banks can still charge for payments refused due to low funds and set their own interest rates for unarranged overdrafts. Depending on the bank, typical interest rates are between 19% to 40%.
While these rates are better than the previous daily overdraft charges, people can still get into serious debt if they don’t manage their spending.
The benefits of overdrafts
When used correctly, overdrafts offer a range of benefits for people. These benefits include:
- Financial Flexibility: Unexpected expenses can put a massive dent in your bank account, but overdrafts bridge that gap. For example, if an appliance breaks and you have to replace it, you might be unable to pay other monthly bills. Having an overdraft means you can cover your expenses in an emergency.
- Convenience and Ease of Use: Overdrafts offer convenience in emergencies and are immediately accessible from your bank account. Loans and credit cards require an application process, but overdrafts are the stress-free solution.
- Avoidance of Insufficient Funds Charges: Without overdraft protection, customers exceeding their account balance could incur an insufficient funds charge or a returned payment fee. Overdrafts help you avoid these fees by completing transactions even if there are not enough funds available.
- Emergency Safety Net: Overdrafts can be a safety net for unexpected emergencies, such as medical expenses or car repairs. It provides a temporary solution until you can arrange alternative funding sources, such as personal loans or lines of credit.
The cons of overdrafts
While overdrafts offer benefits, it’s essential to consider the potential drawbacks and be aware of the following cons:
- Costly Fees: Banks typically charge transaction fees and interest when you use an overdraft. If you don’t repay them quickly, the fees can add up, which means you’ll have more trouble paying them back in the future.
- High-Interest Rates: Many banks charge high-interest rates on overdraft balances, and the interest is typically higher than on traditional loans or credit cards. However, it depends on the overdraft you receive, as some banks offer lower interest rates.
- Potential Debt Trap: According to The Guardian, two million people in the UK live permanently in their overdrafts. This constant state of borrowing can be near impossible to escape from, which means you accumulate more debt over time.
- Impact on Credit Score: Overdrafts can harm your credit score if you don’t manage them properly. Missed and late payments can impact your future borrowing opportunities.
Ways you can use an overdraft to your advantage
According to the Financial Conduct Authority, 15 million people in the UK had overdrafts in 2021. YouGov estimates that the UK is £3.5 billion overdrawn, showing people’s reliance on their borrowing.
However, while overdraft debt is an issue, using one wisely can also ensure you don’t get into debt and have a safety net for unexpected expenses.
The key to making your overdraft work is knowing how to utilise it. Following these tips ensure you get the most out of your borrowing and avoid the pitfalls of overdraft debt.
Evaluate your financial situation
Before you think about using an overdraft, evaluate your current financial situation and whether it’s likely to change. Look at your monthly income and use a budget planner to track your monthly expenses to evaluate how much disposable income you have each month.
You should also ask yourself the following questions:
Is my income stable?
If you’re in a stable job where your situation isn’t likely to change, you can pay off your overdraft each month and ensure you don’t get into debt. However, if you’re a freelancer or don’t have long-term job security, you could become too reliant on an overdraft.
Can I save more money?
It’s also helpful to look at where you spend more money and see if you can cut costs by reducing your reliance on takeaways or switching mobile and internet providers. Knowing your finances and evaluating whether you’re secure will avoid you having to rely solely on overdrafts.
Choose the right overdraft limit
There’s no set overdraft limit; the amount you’re offered depends on the bank and how much they think you can afford. Some people might have an arranged overdraft limit of £300, but some banks will offer up to £5000.
It depends on your income and financial circumstances, but you should consider how much you can realistically afford before agreeing to an overdraft limit.
Set a limit you can afford
Your overdraft limit should be there for emergencies, and assessing your financial situation means you can choose a sensible limit.
Avoid overextending yourself
For some people, a large overdraft is too tempting, and many end up overexerting themselves. Borrowing beyond your means can lead to financial stress and difficulties getting out of your overdraft.
Borrowing only what you need ensures you can avoid debt and pay the overdraft back the next month.
Manage your bank account properly
Everyone with a bank account should know how much they spend every month. Whether you use a traditional budgeting sheet or a mobile banking app, evaluating your spending can ensure you avoid relying on your overdraft too much.
Monitor your account
Monitor your account regularly to keep track of any interest charged against your overdraft. You can also evaluate how much money you spend on luxuries, such as takeaways or going out, and make changes to prevent excessive spending.
Know your interest rates
Overdrafts come with interest charges, and knowing what yours are can prevent you from getting into serious debt. Before agreeing to a limit, read through the terms and conditions and compare rates from different banks to see if you can get a better deal elsewhere.
Pay off your overdraft
While an overdraft provides temporary financial relief, it’s still a form of debt. You should pay off your overdraft immediately to minimise the interest accrued. By repaying the borrowed amount promptly, you can regain control of your finances and avoid unnecessary financial burdens.
What are the alternatives to overdrafts?
Plenty of alternatives are available if you’re unsure whether an arranged overdraft limit suits your needs. By evaluating your financial situation and looking at what you can realistically afford, you can weigh up the pros and cons of each alternative to find the one that works for you.
Emergency savings fund
Building an emergency savings fund is an excellent alternative to relying solely on overdrafts. Setting aside a portion of your income regularly creates a safety net for unexpected expenses.
An emergency fund eliminates the need to borrow and helps maintain financial stability without incurring additional costs.
However, some people like borrowing money because it protects their savings and can boost credit scores.
Personal line of credit
A personal line of credit is another viable option for managing financial emergencies. Like an overdraft, it provides access to funds when needed, but typically at a lower interest rate.
Lines of credit offer greater flexibility in terms of repayment, allowing you to borrow and repay as required within a predetermined limit.
The main issue with lines of credit is that some people borrow more than they need, and if you only make the minimum payments each month, you can incur more debt.
Taking out a loan
If you’re planning a significant purchase, such as buying a new boiler or performing home renovations, you can use a secured or personal loan to fund the purchase. These loans depend on your credit history, but most lenders will let you borrow money and pay a set amount back each month.
As loans are often for higher amounts than overdrafts, you can get a better deal and protect your bank account.
How to get an arranged overdraft that suits your needs
When deciding whether to give you an arranged overdraft, banks look at your credit report to evaluate how much you can borrow each month. Some banks will offer overdrafts to customers with a bad credit rating, but most won’t let you increase your limit unless you build a better score.
If you need to access cash and want to improve future overdraft options with your bank accounts, exploring loans for bad credit is a good idea.
These loans enable you to borrow money and can positively affect your credit score if you pay them off in full and don’t miss any payments.
As banks use credit reference agencies to determine your overdraft limit, a bad credit loan can help improve your options in the future.
The bottom line
Overdrafts are a valuable tool for short-term borrowing, and using them responsibly can prevent debt and ensure you can make emergency purchases. However, building your credit score can open up more opportunities in terms of applying for a current account that includes an overdraft.
Believe Money is one of the UK’s most reputable loan brokers. We help clients like you find the right borrowing solution for your current situation and future goals.
Get a free consultation today, and look forward to a brighter future.
FAQs
Can anyone apply for an overdraft?
Generally, individuals with a bank account in good standing can apply for an overdraft. However, approval and the specific terms may vary depending on the bank and the individual’s credit history. If you’re only eligible for a basic bank account, you won’t be able to apply for an overdraft.
Will using an overdraft affect my credit score?
Regular use of an overdraft and timely repayments can positively impact your credit score. However, consistently relying on an overdraft facility and failing to repay the borrowed amount can have a negative effect.
Can I increase my overdraft limit?
Depending on your bank’s policies and your financial circumstances, requesting an increase in overdraft limit may be possible. However, banks will assess your creditworthiness and repayment history before approving any changes.
Can an overdraft be used for long-term borrowing?
Overdrafts are generally for short-term borrowing needs. Exploring other financial options, such as personal loans or credit cards with lower interest rates, is advisable if you require funds for an extended period.